Rising Tensions: The Impact of the China-Japan Territorial Dispute

The recent flare-up in a long standing territorial dispute between China, the world's second-largest economy, and Japan, its third largest, appears to be cooling slightly, but it is far from resolved. The impact on both economies from violent anti-Japanese protests over disputed islands in the East China Sea is likely to persist at least through next year. If it lasts longer, it could drag down global growth.

The only thing that appears certain is that neither side is likely to back down from the latest round of tensions over the islands, called the Senkaku in Japan and Diaoyu in Chinese. Beijing deems territorial issues as "core issues" on which it will not waver. The ruling Communist Party, in the midst of a top leadership transition, has relied heavily on fanning nationalist sentiment to fortify its own claim to power. The bout of anti-Japanese demonstrations that erupted in August was a reminder of how volatile such nationalism can be. While protests in Japan were much tamer, and confined to a much smaller segment of society, the government is unlikely to defy right-wing groups by compromising on Japan's claim to islands it has controlled for over a century.

While Beijing appears to have ordered an end to the anti-Japanese marches it apparently condoned earlier, Chinese vessels have continued to prowl near the islands. In mid-October, Japan's Defense Agency reported that seven Chinese military vessels were spotted near Yonaguni, an island in southwestern Japan that is not part of the Senkakus, in one of the boldest incursions so far. A military conflict could break out, many analysts worry, if there were an accident between a Chinese patrol ship and Japan's Coast Guard vessels.

This round of tensions differs from ones that surfaced in 2005, because China has become stronger economically and militarily and far more assertive than it was seven years ago. "Japan-China relations have changed since 2005, which was the final year that Japan provided ODA (official development assistance) to China," says Tomoo Marukawa, a specialist on the Chinese economy at Tokyo University's Institute of Social Sciences. "China has become so confident about its economic strength, and some Chinese are calling for economic sanctions against Japan," he says.

The anti-Japanese demonstrations in 2005 stemmed from anger over the approval of a Japanese history textbookthat Chinese said whitewashed Japan's 20th century war crimes. They also were in opposition to a proposal that Japan be granted a permanent seat on the United Nations Security Council. Protesters were bused to Japan's consulate in Shanghai, which suffered major damage, as did a few businesses. The current spate of protests followed moves by Japan to nationalize the previously privately held islands, ostensibly to prevent their sale to the Tokyo city government, which is headed by nationalist Gov. Shintaro Ishihara.

No Longer Dependent

Marukawa believes China's approach to Japan this time is much stronger than in 2005 partly because it is confident it can make do without the Japanese-made components that so many of its industries rely on for their assembly manufacturing. In so thinking, it may be counting on alternative sources, such as South Korea, that it used to cope with supply chain disruptions from Japan's massive earthquake in March 2011, he says.

In 2010, China appeared to be using its control of rare earths supplies as a diplomatic weapon against Japan following the arrest of a Chinese fishing vessel captain after the collision of his ship and a Japanese patrol ship near the disputed islands. In September of that year, China suddenly halted shipments of rare earths to Japan, the U.S. and EU without notice. So far, this time the rare earths issue has not resurfaced, perhaps because since then Japanese and other users of rare earth metals have diversified their suppliers.

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This time around, the attacks were more widespread and virulent, and are likely to cause lasting damage to Japan's extensive manufacturing operations on the Chinese mainland. The Japanese car industry was hardest hit as mobs targeted Japanese brand vehicles, in some cases smashing them or setting them on fire. Japanese carmakers temporarily closed dealerships as a precaution and reduced output. Toyota reports that its car sales in China fell by 48.9% from a month earlier to 44,100 units in September. Honda's sales, meanwhile, dropped by 40.5% from a month earlier to 33,091 units. Overall, according to the China Association of Automobile Manufacturers, sales of Japanese brand vehicles sank 29% in September from a year earlier.

This unwelcome news prompted the Japanese government to cut its growth assessment for a third straight month in mid-October due to the "external prospects affecting export growth." The slowdown in trade with China, Japan's biggest trading partner, clearly is taking its toll. In 2011, two-way trade between China and Japan totaled more than US$340 billion. China is both Japan's biggest export destination, buying about 18% of the goods it ships overseas, and also the biggest source of its imports. But Japan is only China's fourth-largest trading partner, after the E.U., U.S. and ASEAN. "We assume that exports to China would decrease by 30% in one year. In such a scenario, Japan's nominal GDP growth rate would fall by 0.6%," forecasts Naoko Nemoto, a credit analyst for Standard and Poor's in Tokyo.

A Lot to Lose on Both Sides

In the longer run, the recent bout of hostilities is going to affect trade and investment in China by the Japanese. "Both sides have a lot to lose. I think both rely on each other significantly," says Patrick Chovanec, a professor at Tsinghua University's School of Economics and Management. Japanese car manufacturers, were they to withdraw or pull back, would be ceding not just production capacity but also their commitment to the Chinese market — the world's biggest and, until recently, fastest growing. "I don't think any Japanese companies have the option of saying they will close up or reduce their presence," he says. "What are Japanese companies going to do? Walk out on the Chinese market?"

Despite some calls for Chinese consumers to boycott Japanese brand goods, most of the damage so far appears to be confined to the painfully vulnerable auto sector. Although retailers also suffered serious damage to some of their outlets in China, Aeon Co. Ltd. and Seven & I Holding Co. are likely to be only slightly affected by the diplomatic row, according to Nemoto. Japanese convenience stores like Lawson are continuing with their expansions on the Chinese mainland. Lawson plans to increase the number of its shops to 10,000 by 2020, from 393 stores as of August 31 this year. "Although many people obstructed our business operations at the time of the anti-Japanese protests, the situation is a lot calmer now," Takeshi Niinami, president of Lawson, said at a press conference.

For China, the impact from disruptions over the dispute is largely related to employment. Japanese businesses employ tens of thousands of Chinese workers, and many others rely on their incomes and spending. Likewise, the uncertainties raised by the conflict could ripple across Asia. "The negative impact on the Chinese economy would increase if bilateral tensions are prolonged," said Nemoto. "In this scenario, investment and international trade activities in the East Asian region may be affected by the heightened state of geopolitical uncertainties."

For now, Japanese companies will likely keep a low profile and hope the current anti-Japanese mood will dissipate. In the longer run, they may indeed consider shifting investments to elsewhere such as ASEAN countries, says Franklin Allen, a finance professor at Wharton. The trend has been toward more, rather than less investment: Japan's direct investment into China was up 16.9% in January-June this year from the same period a year ago, and Japan is the third-biggest foreign investor in China, accounting for 6.9% of the total in 2011. There is already sign that Japanese investment into China has declined. Japanese M&A activities in China in July-September dropped about 70% to 5.6 billion yen from the previous quarter, according to advisory firm Recof Corp.

A Dire Miscalculation

How did things get so far out of hand? It appears, based on accounts in the Japanese media, that Japanese Prime Minister Yoshihiko Noda made a dire miscalculation in thinking that the national government's purchase of several of the islands, in lieu of a purchase by the Tokyo Metropolitan government, would mollify Beijing. Ishihara, the Tokyo governor, proposed buying the islands in April and planned to develop them — moves China would have viewed as an attempt to further solidify Japan's claim to the rocky outposts, which are uninhabited apart from dozens of feral goats. The Japanese central government has pledged to keep the islands, which are thought to sit atop potentially valuable oil and gas resources, undeveloped. But Beijing views any actions asserting Japanese control as unacceptable, while Tokyo insists on its historical claim to the islands.

Since China quelled the anti-Japanese riots in late August and early September, it has confined its actions to the realm of rhetoric and diplomacy. China cancelled official celebrations in Beijing of the 45th anniversary of the normalization of ties. The Chinese finance minister and central bank governor, as well as several senior bankers, stayed away from the annual meeting of the International Monetary Fund and World Bank, which was held in Tokyo in mid-October.

The two sides exchanged angry tirades at the U.N. annual General Assembly last month, where Kazuo Kodama, Japan's U.N. ambassador, flatly rejected Chinese Foreign Minister Yan Jiechi's declaration that "the Chinese side will by no means tolerate any unilateral action by the Japanese side on the Daioyu Islands. China will continue to take firm measures to safeguard its territorial integrity and sovereignty." Kodama reiterated Tokyo's stance that the islands belong to Japan, based on "historical facts and international law…. China's assertions have no grounds at all," he said.

In the past two weeks, officials on both sides have held quiet meetings in preparation for formal talks. Ultimately, it is hard to imagine how the standoff can be defused. So far, the U.S. has sought to remain neutral. "The Japanese government and Japan-China trade and business groups do not have strong relations with China or special channels to reach top Chinese officials under this kind of situation," says Konosuke Takegami, professor at Takushoku University's Graduate School of Commerce. For dealings with China, Japan has depended on the U.S., he says. "But the U.S. is not going to help Japan unless there is some kind of military conflict."

For now, the situation remains perilous. The U.S. and Japan sent a signal of unity to China with joint military exercises in Guam in later September, though nobody wants an open confrontation, says Chovanec. "But there are patrol boats floating around that could easily crash into one another. It does not take much miscalculation for someone to get hurt. It is a very dangerous situation right now," he says.

Ultimately, Japan needs to reformulate a long-term strategy for dealing with China, whose economy has surpassed it in size, though the Japanese people themselves appear not to have realized how powerful it is. "What alternative does Japan have? Japan does not have strong military power like China and does not have the strong economic power it used to. China now has both," says Wharton's Allen. "In the end, in the next few years the Japanese government has to decide what it will do about dealing with China. Are they going to let the Chinese dominate and push them around?"

Japan's own political situation is compounding the uncertainty, given the possibility that the next election, due by the summer of 2013 at the latest, could return the more conservative Liberal Democratic Party to power. The LDP's recent selection of hawkish former Prime Minister Shinzo Abe as its secretary-general virtually ensures that the issues will likely flare up again, Allen says. "The problem will not go away any time soon." Chovanec agrees: "It is going to go on for while because there is not much room for comprise."